Markets & Finance

Shanda: A Compelling Play in Chinese Web Games


S&P has a "strong buy" ranking on the American depositary receipts of the company, which operates MMORPGs, citing their attractive valuation

From Standard & Poor's Equity ResearchWe believe Shanda Interactive Entertainment (SNDA); recent price, $27), an interactive entertainment media company, is a diversified leader in a large and growing market. China is the world's largest online gaming market, and Shanda generates more revenues from online gaming than any other company. Shanda offers many different games in different categories, owns PC and mobile gaming platforms, is building an in-game advertising business, and is home to China's most popular original literature portal. The company's past success has provided it with notable resources to bolster its game pipeline and build out other operations, by our analysis.

In addition, we believe the upcoming Beijing Olympic Games could very well be a positive catalyst for the company and its American depositary receipts (ADRs). Initially, the eyes of the world will be on China, and we think that people will come to learn more about what we consider its compelling national growth prospects and perhaps seek out related U.S-traded investment opportunities. We also believe Shanda could benefit from government-mandated actions restricting business operations and driving that could increase consumption of the company's offerings in homes and local Internet cafés.

We think Shanda trades at a compelling valuation. The ADRs carry Standard & Poor's highest investment recommendation of 5 STARS (strong buy).

COMPANY PROFILE

A pioneer and leader in the Chinese online games segment, Shanda provides a variety of Internet games, and increasingly, other digital content. Its offerings consist primarily of online games that it develops in-house or licenses from third parties. Almost all of the company's revenues are generated from online games, including so-called massively multiplayer online role-playing games (MMORPGs) and casual games. In 2007, these two categories accounted for 96% of revenues.

The company's MMORPGs are largely action/adventure-based, and often draw upon martial arts and combat themes. Each MMORPG constitutes a virtual world in which players interact with one another. Typically, users assume ongoing roles with different attributes, and each character can gain experience and collect certain benefits (such as weapons or points) that increase his/her game abilities and/or status. In addition, groups of players often form alliances and teams to fulfill certain game objectives. As of yearend 2007, Shanda offered 11 MMORPGs, seven of which the company owned.

Importantly, in our opinion, in November 2005, Shanda announced that it would not charge users for playing some of its MMORPGs, and that it would charge only for certain in-game items or features. Previously the company had employed a "pay-to-play" model for all of its MMORPGs.

Shanda's casual online games generate revenues primarily from premium features (not from just game-play). We believe casual games are an important component of Shanda's growth strategy, as advertising is increasingly provided in free gaming experiences, and users become more accustomed to paying for certain features. Casual games also attract a broader range of users, as well as more home users, compared with MMORPGs.

As of December 2007, Shanda offered nine casual games, five of which were developed internally. These include battle games and fighting games, among others.

In July 2004, Shanda acquired Hangzhou Bianfeng Software, which offers a variety of casual games, including card games, board games, mah-jongg, and simple arcade games. In December 2005, Shanda purchased Gametea, a developer of chess and board games.

The company also provides original literature via three Chinese language portals, Qidian.com, Jjwxc.com, and Hongxiu.com. Through these offerings, Shanda publishes original works of independent writers. Users can access certain sections of these works for free, and pay membership fees to read complete works and access more content.

In addition, Shanda operates a PC computer game network where users can find and connect with other players of the games. The company does not own or license content on the platform. It also develops and offers nearly 500 mobile games through Digital Red, which it acquired in October 2004. Digital Red also provides mobile versions of two of Shanda's most popular games, and plans to offer other services.

INDUSTRY OUTLOOK

According to the China Internet Network Information Center (CNNIC), earlier this year China became home to the world's largest Internet population. In June 2008, there were 253 million people online in China, while the U.S. had 223 million users, per data from Nielsen Online.

The number of online users rose 53% in 2007, according to CNNIC. However, online penetration in China is only 19%, compared with 71% in the U.S., indicating, we believe, that there is considerable potential for future growth.

Not surprisingly, China also has the world's largest population of people who play online games. CNNIC has estimated that 60% of China's Internet users play online games at least once a year, with an average of more than seven hours played per week. According to CNNIC, more than one in every five of China's online gamers played more than 10 hours a week. This is substantial activity, in our view. In fact, we believe that China's online gaming population and market could double in size from 2007 to 2012, translating to average annual growth of 20%.

COMPANY POSITION AND STRATEGY

China's large and high-growth online gaming market has attracted a number of participants and offerings. Nonetheless, Shanda has been for some time the country's largest purveyor of online games, based on revenues. And we believe the company is a category leader in more ways than one.

For example, in 2005, Shanda was the first company to adopt a "free-to-play" business model, and, while its MMORPG business and American depositary receipts (ADRs) were adversely impacted over the near term, the company persisted, and developed these offerings quite effectively and successfully, in our opinion. In fact, while Shanda's MMOPRG revenues declined in 2006, growth in 2007 was 65%, and we foresee an average annual increase of 28% from 2008 to 2010.

As indicated earlier, the company has a number of businesses and different offerings, and owns more than half of its MMORPGs and casual games. We believe notable diversification efforts have improved the company's growth prospects, and have reduced Shanda's reliance on third-party developers. It has also helped Shanda build what we believe could be China's first substantial in-game advertising business.

Shanda has achieved this diversification in part via an active and thoughtful acquisition program. Last year alone, Shanda invested in some 15 companies after evaluating more than 200.

Through acquisitions, the company has built China's pre-eminent literature portal (which consists of three constituent web sites). It has more than 20 million registered accounts and generates 220 million page views per day. This portal is considerable, having more registered users than the unique visitors of the online versions of The New York Times and Wall Street Journal combined. And registered users are much harder to come by, in our opinion.

We think Shanda could look to monetize its in-game advertising business, literature portal, and even its PC games network and mobile games business in a variety of ways. Most logically, we think, would be sales of partial or entire interests or initial public offerings.

VALUATION

Shanda is not only a diversified market leader, but we believe it also trades at a compelling valuation. We estimate that the company will generate 2008 earnings of $2.09 per ADR, which translates to a price-to-earnings ratio of about 13 times, at recent levels. This is lower than the recent P-E's of the S&P 1500 (15 times), the S&P 1500 Technology sector (18 times), and the S&P 1500 Internet Software & Services subindustry (27 times), also using 2008 estimated EPS.

With our per-ADR earnings forecasts of $2.51 for 2009 and $2.99 for 2010, Shanda's related three-year average annual growth is 18%. We believe that this expected growth rate is considerably higher than those for the S&P 1500, S&P 1500 Technology sector, and the S&P 1500 Internet Software & Services subindustry. Essentially, Shanda is less expensive on a P-E basis, yet offers more growth potential, by our analysis.

In fact, we calculate Shanda's P-E-to-growth (PEG) ratio at 0.7 times using estimated 2008 earnings and our 18% growth forecast, which is considerably lower than those we have projected for the S&P 1500 (1.2 times), the S&P 1500 Technology sector (1.1 times), and the S&P 1500 Internet Software & Services subindustry (1.1 times).

Although these comparisons indicate that Shanda is undervalued, we believe more focused peer considerations are the best way to help confirm this assessment and derive an appropriate target price.

We reviewed a relatively broad group of what we consider Shanda's peers, including Asia-based Internet companies whose ADRs trade in the U.S. On average, the ADRs recently had a 2008 P-E of 26 times and PEG ratio of 0.8 times. Shanda's recent P-E was about 50% below this group's, and its PEG was more than 10% lower. Applying these peer multiples to Shanda and weighting the results with our P-E analysis leads to our 12-month target price of $40.

We also think it is relevant to again mention that Shanda has a number of noncore businesses that we think could perhaps be better monetized through some kind of corporate activity. We think the literature portal looks especially interesting in this regard.

Lastly, Shanda had $464 million in cash, cash equivalents, and investments as of March 2008, amounting to $6.32 per ADR.

CORPORATE GOVERNANCE

Shanda has a very complicated corporate structure, in part because of its considerable acquisition activity over the past number of years. It is a Cayman Islands holding company, and has operating businesses domiciled in mainland China and Hong Kong. The company also owns a majority stake in a business based South Korea. In total, Shanda has some 35 separate subsidiaries and investees. We think this complexity detracts from corporate governance and transparency.

The company's co-founder, chairman, and CEO, Tianqiao Chen owned some 43% of company as of March 2008. Around the same time during the prior year, he controlled about 56% of Shanda's shares. While we generally believe it is good for corporate managers and directors to own significant stakes in their companies, therefore aligning their interests with those of shareholders, we find Chen's multifaceted ability to control the company as its leading executive, head of the board of directors and Shanda's by far largest single share owner somewhat worrisome.

As of June 2008, Shanda had nine directors, a majority of which were not company employees. We note that one of the directors was Chen's wife.

The board of directors has adopted a code of ethics that is applicable to its senior managers and a code of conduct that is applicable to all of Shanda's employees. It has also adopted a set of corporate governance guidelines and established a disclosure committee.

Overall, we believe that Shanda's corporate governance is somewhat lacking, but not substantially so, especially compared to peers.

INVESTMENT RISKS

Risks to our recommendation and target price include weaker demand for offerings than we foresee, perhaps related to global economic challenges or China-specific events, such as the May 2008 earthquake in the southwestern part of the country, more significant competition in terms of both companies and offerings, potential business execution issues, especially as Shanda focuses on building its game pipeline and diversifying its operations largely through acquisitions and strategic investments, and possible adverse regulatory developments initiated by the Chinese government, especially related to online content and taxation.


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